Fed's exit from stimulus 'likely to be messy'

Investors are contemplating a future without support from one of the biggest drivers of the global economy in recent years - the US Federal Reserve.

Investors are contemplating a future without support from one of the biggest drivers of the global economy in recent years - the US Federal Reserve.

Fears that the Fed is about to reduce its stimulus helped send stock, bond and currency prices on a wild ride this week, with Japanese stocks experiencing their worst one-day decline since the 2011 tsunami.

Around the world, traders debated the significance of the statement made on Wednesday by Fed chairman Ben Bernanke, that a change of the central bank's policy could come soon.

The sweeping stimulus programs initiated by Mr Bernanke have helped feed a four-year rally in US stock prices and inspired other central banks to follow suit.

But even fans of the Fed's efforts have said that the size and scope of the stimulus make it hard to know what will happen once the Fed takes its foot off the gas, paving the way for unanticipated consequences.

"There are no neat answers, because we've never been in this situation before," Marshall Front, co-founder of money manager Front Barnett Associates, said.

Fed officials are well aware of the confusion that lies in store and have emphasised that any changes are still a way off and are likely to be carried out slowly.

After Mr Bernanke's appearance before Congress, the president of the St Louis Federal Reserve Bank, James Bullard, said in a speech in London that even after the central bank began to slow down monetary stimulus, policy makers could step in again if the economy showed signs of faltering.

Speculation the Fed would slow its monthly purchases of government bonds has been growing for months. Investors knew the central bank's efforts could not continue forever, and many asset managers had begun to prepare their portfolios for the day the Fed pulled back.

Front Barnett has sold all its long-term bonds to reduce exposure to changes in interest rates, and it no longer holds any Treasury bonds. In a more optimistic vein, it has been shifting money into riskier stocks on the assumption rising interest rates will be accompanied by growing economies around the world.

When the Fed does shift gears, the process will begin with a slow tapering of bond purchases. Even that will commence only if the US labour market grows stronger and unemployment falls further.

The economic data coming out of the US on Thursday showed slight signs of improvement. The number of people who filed for unemployment benefits last week was 340,000, lower than the week before. The number of new homes sold rose to the highest level since 2010.

The US housing market has been one of the biggest beneficiaries of the Fed's purchases of government and mortgage-backed bonds. When the Fed slows these purchases, mortgage rates can rise, exerting a new drag on the housing market.

How investors respond to the Fed's policy will determine how the US economy is affected. That will be hard to predict even for the smart minds at the Fed, William O'Donnell, head of Treasury bond strategy at RBS Securities, said.

"We've supported the Fed's actions for a long time," Mr O'Donnell said, "but we've long harboured fears that the exit is likely to be messy with lots of unintended consequences."

The harshest critics of the Fed are worried that a change in policy could pop what some believe to be a bubble in share prices. Peter Andersen, a portfolio manager at Congress Asset Management, has been buying growth-oriented stocks in preparation for another rise in the market. He noted that the Fed was likely to let interest rates rise only if the economy was improving, which would in turn help stocks.

Whatever the uncertainty in the US, the picture is even murkier overseas. The Japanese government, which has been trying to follow the Fed's lead in stimulating its own economy, faced a setback on Thursday in the plummet of the Nikkei.

The drop marked a sharp reversal for a market that has been one of the world's best performers this year, thanks to the economic shock therapy by Prime Minister Shinzo Abe.

There was disagreement about what had caused the dive. The Fed took some of the blame, as did the release of weak data on China's manufacturing sector.

China's slowing momentum has been deliberately engineered by the authorities in Beijing, who are trying to bring about a more balanced pace of growth. Still, disappointments over the performance of China's economy remain liable to unsettle markets around the globe.

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